Chapter 36. Six debates over Macroeconomic Policy. Exercises 1-4
Principles of Economics. Chapter 36. Six debates over Macroeconomic Policy. Exercises 1-4. Gregory Mankiw. 8th edition.
1. The chapter suggests that the economy, like the human body, has “natural restorative powers.”
a. Illustrate the short-run effect of a fall in aggregate demand using an aggregate-demand/ aggregate supply diagram. What happens to total output, income, and employment?
b. If the government does not use stabilization policy, what happens to the economy over time? Illustrate this adjustment on your diagram. Does it generally occur in a matter of months or a matter of years?
c. Do you think the “natural restorative powers” of the economy mean that policymakers should be passive in response to the business cycle?
2. Policymakers who want to stabilize the economy must decide how much to change the money supply, government spending, or taxes. Why is it difficult for policymakers to choose the appropriate strength of their actions?
3. The problem of time inconsistency applies to fiscal policy as well as to monetary policy. Suppose the government announced a reduction in taxes on income from capital investments, like new factories
a. If investors believed that capital taxes would remain low, how would the government’s action affect the level of investment?
b. After investors have responded to the announced tax reduction, does the government have an incentive to renege on its policy? Explain.
c. Given your answer to part b, would investors believe the government’s announcement? What can the government do to increase the credibility of announced policy changes?
d. Explain why this situation is similar to the time-inconsistency problem faced by monetary policymakers.